Intergenerational financial planning strategies

[ November 20, 2015 ]

How and When to Help the Adult Kids

In this Friday Reflection, we cast our eye over some strategies that can be used when a vertically extended family is treated as if it is, in fact, one large client. This kind of vertical integration across the generations is known as intergenerational financial planning. Intergenerational financial planning is a long thing to keep writing, so we will call it IFP for short.

The Potential of Intergenerational Financial Planning

IFP has incredible potential for most clients. Mediterranean, Middle Eastern and Asian families often pick it up quickest: it’s long been part of their culture. In IFP, managing money with the extended family in mind is the key. It is less important who owns the investment. The idea is to maximize the after tax returns to the family. Investment time horizons can be measured in decades, even generations, rather than years.

Trusts, companies and SMSFs each have a role to play, as does the careful creation of deductible debt, in the right place and at the right time.

As the name suggests, IFP is where the adviser thinks beyond the immediate needs of the client sitting in front of him or her, and instead extends the thinking ‘upwards’ to older members and ‘downwards’ to younger members of the client’s family.

All Clients Are Likely Candidates for IFP

We think advisers should see all clients as potential candidates for IFP. We recommend advisers try to spend a little extra time with all new clients finding out a bit more about the person, their life views and their relationships with friends and family. The purpose is not completely social. Often the extra time reveals important facts, hopes and attitudes you can then blend into your advice and strategies, making them better than ever.

This social glimpse allows you to filter your advice and make sure it is relevant and pertinent. Often a glimpse reveals a client supporting elderly parents or young (and sometimes not so young) adult children – and sometimes both. This immediately raises the question of whether these responsibilities can be synthesized into the client’s overall financial plan. It frequently can.

Research

We came across some interesting research recently which has very much focussed our mind on the importance of inter-generational financial planning. The research was conducted by the Grattan Institute and released in December 2014.

Amongst the other parts of the report, the following graphs caught our eye:

people-in-their-50s-60s-receive-larger-inheritances

What the graphs show is that a person’s prospects of receiving an inheritance peak in that person’s 50s and 60s. This would seem to reflect the fact that most people inherit from their parents, which is happening quite late in the inheritors’ life as their parents live into their 80s and 90s. (We expect that the more than 5% of inheritors who receive inheritances in their 80s receive them from age-peers such as siblings, or even adult children, rather than parents).

By the time inheritors have reached their 50s or 60s, the impact on their own lives of a substantial inheritance is lower than it would have been had that assistance been available earlier. By the 50s and especially the 60s, most people have completed the most expensive years of their lives – the child-rearing years. The inheritance might make for a nicer retirement, but you cannot help but wonder: how much more utility would the family as a whole have had if the recently-inherited wealth had been shared out among the rest of the family sooner?

This is where IFP really comes into its own. It assists with the transfer of wealth between generations so that the maximum utility for the family as a whole is achieved.

The Importance of Strategies in Effective IFP

Perhaps more than in any other area of financial planning, effective IFP requires a commitment to creativity in the development of strategies for clients. In the sections that follow, we offer some strategies that we have developed ourselves that are designed to facilitate IFP. Please feel free to think about them, tinker with them and, as ever, offer us your thoughts on them – or indeed any other strategies that you apply when it comes to IFP.

Strategies for Clients with Low-to-Average Wealth

Retired Mum Helping Single-Parent Daughter

Margaret is a widowed client in her late 60s. She owns her own home worth $650,000 and has $300,000 in a SMSF. She is naturally cautious and withdraws $2,000 per month from her conservatively invested fund. Other than this she lives on the old aged pension.

Margaret’s daughter Kylie is doing things very tough. She is a single mum aged 45 with three school-aged children. She received the home – and a $250,000 debt – in the divorce and her ex-husband does not pay child support. She earns $60,000 salary and receives some family tax benefit on top of that.

Margaret and her deceased husband Kenny worked hard to own their own home. But there were two of them. Margaret is worried how Kylie will ever own her own home, and desperately wants to help out with more than just childcare. It really cuts Margaret up to see how tough her daughter is doing it. But Margaret is also aware that she needs to ensure that her own wealth lasts the rest of her life. She would love to simply pay off Kylie’s home loan but worries that this will leave her (Margaret) too vulnerable as she enters old age.

The Adviser to the Rescue – Use Super to Supercharge the Loan Repayment

Her adviser has an idea. The adviser suggests that Kylie speak to her lender about rendering the loan interest-only. At 4.75% interest, this equates to a cost of $11,700 per year. Given her marginal tax rate, Kylie has been earning $17,333 before tax in order simply to meet this interest expense. The principal repayments saved equate to $450 per month. This is a straight-out increase in Kylie’s after-tax spending money.

The adviser then suggests that Margaret undertake to meet the interest expense of $11,700 per year. This will not place undue stress on Margaret’s own resources, but it will be a huge bonus for Kylie. Kylie then instructs her employer to sacrifice an extra $18,500 as a deductible super contribution. This amount is only taxed at 15% in the super fund, so Kylie accumulates an additional $14,733.

So, Margaret has given up $11,700 and Kylie has acquired an asset worth $14,733. This is an immediate return of 25.9% on Margaret’s ‘investment’. It is the best return the family is going to get, and it then accumulates in the low-tax environment of Kylie’s super fund. We calculate that Kylie’s loan, which she is currently slated to repay on the day of her 70th birthday (25 years from now – our figures are calculated assuming a 25 year loan repayment period), will have been offset by the additional amounts in super by the time Kylie reaches the age of 58 – and probably earlier, given the impact of inflation. The effective period of the loan has been halved, all because of the strategy that was implemented:

  • adapt the loan to be interest-only;
  • have Kylie increase deductible super contributions;
  • use Kylie’s super to accumulate the wealth needed to retire the loan principal; and
  • have Margaret use a small amount of her own non-home assets ($11,700 is less than 4% of her $300,000 super balance) to keep the bank happy.

We have prepared a simple sample SOA here to demonstrate how this could be communicated.

Assuming no substantial changes, Kylie and Margaret repeat this for the next fifteen years, by which stage Kylie turns 60, her kids are independent, and she can make a tax-free withdrawal of $250,000 to pay out the home loan, with some extra super left over.

Kylie has been assisted to pay off her own loan while also increasing her day-to-day cash-flow during the peak cost years of her own life.

She has been able to do this because she has effectively received a small part of her inheritance when she needed it most.  That is what IFP can achieve.

Remember: Housing is an After-tax Expense

Very commonly, the main focus of IFP is to provide housing for the younger generations – at least, housing that is within a sensible distance of where Grandma and Grandpa are living.

Accordingly, it pays to remember that, ultimately, private housing must be bought using after-tax dollars. The deposit used to purchase a private residence, for example, must be saved after tax is paid on the purchaser’s income. The principal and interest payments on the loan must also be paid out of after-tax income. Ultimately, the whole property is paid for after-tax.

As a result, it becomes clear that, where the tax payable on income is lower, it will require less pre-tax income to buy the same amount of house. The following table shows how much pre-tax income is required to buy a $500,000 property for various marginal tax rates.

Tax Rate

Pre-Tax Amount Required

Tax Paid

Amount Remaining

0%

$500,000

0

$500,000

15%

$588,235

$88,235

$500,000

19%

$617,284

$117,284

$500,000

32.5%

$740,741

$240,741

$500,000

37%

$793,651

$293,651

$500,000

45%

$909,091

$409,091

$500,000

The second column shows the pre-tax cost of a $500,000 property. The 15% tax rate is that rate payable on deductible super contributions into a super fund. The point of the table is this: if families make deductible super contributions into someone’s super fund, and then withdraw these contributions tax-free when the relevant person reaches the age of 60 and use it to pay for housing, the family only needed to earn $588,000 pre-tax to buy the $500,000 property. If the relevant part of the family instead pays tax on income at 45%, and then uses what’s left to pay off the loan directly, the $500,000 property costs over $900,000.

Judicious use of super can reduce the cost of a property by more than a third.

Because of this, wherever a property needs to be purchased somewhere within a family structure, it pays to think about whether the super effect can be utilised.

Mum in her Fifties Helping Young Adult Son

Consider another example. Janet is a client in her late fifties. She became a mum at 35 and her son Niall is graduating from Uni at the age of 22. Janet owns her home and is securely employed. An elderly aunt died recently and left Janet $40,000. She does not really need the money and so decides to give it to Niall to kick off his saving for as a home deposit. He calculates that he needs an extra $40,000 and that it will take him three years to save this much. He is adamant that he will not buy a home before then – he wants to travel. 

If Janet gives the money to Niall now, he will place it in a term deposit earning 2% per annum. In three years, this will be worth around $42,500. That’s if he does not blow it on his overseas trip. 

Janet’s adviser Noni has another idea. Janet earns $65,000 a year as a senior administrator. Noni suggests that Janet sacrifice an extra $20,000 in salary as a deductible super contribution each year for the next three years. Given her tax rate, this only costs her $13,500 in lost purchasing power each year. She replaces this lost purchasing power with a portion of the $40,000 inheritance. Within her super fund, she accumulates an extra $17,000 each year, after tax. If this is placed in a conservative investment (akin to the term deposit), she can expect to have around $52,000 in three years’ time. Having reached the age of 60, presuming she meets a condition of release, she can withdraw this amount tax-free and give Niall almost $10,000 more than he would have if she gave him the money now.

The logic is the same as with Kylie and Margaret, but the roles are reversed. In Kylie’s case, the adult child had the super fund. In Janet’s case, it was the mum. This is the reality of IFP: someone, somewhere, will often be in a situation to make use of super as a strategy for maximising the utility of the entire family. 

Self-Employed Parents and their Troubled Daughter’s Dopey Boyfriend

Bill and his wife Joan own a reasonably successful plumbing business. As they met with their adviser, the small-talk at the start of the meeting revealed that they were dismayed that their 20 year-old daughter Lisa has moved in with her boyfriend of 10 months to raise their new baby girl together. Not surprisingly, the young couple were flat broke. The daughter was forced to cart Bill and Joan’s precious grand-daughter around in a 20 year old bomb likely to blow up at any time. Joan was having kittens.

The solution was for the adviser to recommend that the business buy a ‘new second hand’ Volvo station wagon, with all the modern safety features, to be provided to Lisa as a fringe benefit. Lisa is their daughter and is thus defined as an employee for these purposes. They also gave Lisa a credit card with strict instructions that it be used to pay expenses of the car. The statement went to Joan so she could keep tabs on these things. 

The costs of the car were deductible for the business (which operated using a trust with a corporate trustee), with just a little FBT payable each year. Lisa sold her old car to buy extra things for the baby. This strategy reduced the family’s tax bill by about $8,000 a year, being the tax benefit connected to the $17,000 of car costs incurred each year, including $8,000 of depreciation.

Strategies for Older Clients with Above-Average Wealth

Higher Wealth Parents (1) – Trust Distributions to Lightly-Taxed Family Members

The previous examples may suit clients of relatively-modest means. It is often the case that IFP takes place where the family has a more substantial amount of wealth.

As we have said elsewhere, the best way to become wealthy is by owning a business. And business owners typically use some form of business structure to best manage the income of that business. Consider another example:

Sue is a lawyer working for ASIC who is currently taking time out of work to have and look after her young children. Her parents owned a business that was quite successful. They have always invested their excess earnings via a family trust, and this proved to be a very good strategy: net income including net capital gains were distributed to Sue and her otherwise low-income-earning-and-thus-low-marginal-tax-paying sisters after age 18, effectively paying for their university educations.

Sue and her husband have just bought a new home and have a non-deductible debt of $250,000. Sue’s husband is employed as an ATO auditor. The interest on the home loan is $12,500 a year, and Sue’s husband has to earn about $20,000 in pre-tax income to cover this cost. The ATO is cutting back staff and Sue fears her husband may be retrenched.

In talking to her adviser, it became clear that Sue’s parents’ family trust’s balance sheet included unpaid distributions to Sue of more than $200,000, dating back to her student days and later her back-packing days. At those times, the trust was able to use the unpaid distributions to reduce the tax paid on its income.

The solution was simple: the trust actually paid the $200,000 to Sue and she used it to repay most of her non-deductible home loan. In effect, this allowed the private debt of today to be repaid using income that had been taxed at low marginal rates in previous years.

Sue’s parent’s family trust can now continue to distribute $18,000 a year tax free to Sue, and $441 a year tax free to each of her children. This will save her parents about another $10,000 a year in tax. These tax savings are invested in new investments and debt reduction, reducing risk and improving future investment returns for the family, including Sue, her sisters and their kids.

And Sue’s parents are reassured because, if she and her husband divorce, the ex-husband will not be able to access these benefits.

Real family trusts can make real family sense.

Higher Wealth Parents (2) – A Home for Every Child

The world of work is changing, and most higher-wealth parents know better than to assume that their children will enjoy safe employment with just one or two employers during their working lives. More probably, as Hugh Mackay tells us, they will have a “patchwork” of part-time and casual engagements, with nothing like the secure tenure that typified their fathers’ and mothers’ employment experiences.

Add to that the increasing unaffordability of housing, and many older people worry that they will never live within a reasonable distance of their grandchildren. Alternatively, they may worry that their adult children will never be able to afford to move out.

The entry price into most popular suburbs in major cities is often too high for most people under age 40 – even those in well-paid employment. Frequently, a new home is only afforded with a bit of discrete help from Grandma and Grandpa. It’s just not possible otherwise, particular if there are kids in the kitchen or buns in the oven.

What will housing prices be like in two decades time? Who knows?

How will your clients’ children afford to pay these prices? Who knows?

What can advisers do about this? Simple. Encourage those clients who can afford to to ‘buy’ their child a home now. It does not have to be something the child will actually live in when they are 50. But it should be in a major city and have good growth prospects.

Clients should not necessarily actually give the child the home. But they should consider bringing a ‘home for every child’ into the family now. Doing this in effect insulates the family against future home price increases and protects the next generation against the risk of runaway home prices.

If a client’s home is worth, say, $1,000,000, and is paid off or nearly paid off, many of the banks will lend that much again for a second home at home loan rates without too much fuss or bother. Clients should make sure the interest rate is the same as the home loan rate: the banks may try to squeeze an extra percentage point or two here, and have been known to tell clients that they have “no choice but to charge that bit extra when the loan is for an investment.”

The tax maths show that a relatively small after tax cost to Mum and Dad in the early years spares the child a large before tax cost in the later years. This sparing gives the child a real economic head start in life and, with a bit of luck, the child’s own efforts will amplify this head start many times over. The bottom line is that it can be almost cash-flow neutral to fully gear a rental property if the interest rate is 5% and the rental yield is 3%.

Perhaps the homes are owned through a family trust and the children just live in them later on while saving for their own homes and investments. This has the added advantage of protecting those children against the risk of losing assets in divorce. Remember, the divorce rate is more than 50% for young marriages.

This strategy can work with one, two or even three children – it depends on the income of Mum and Dad, of course. Even for very wealthy parents, the maths becomes a bit daunting with four or more children, but perhaps here the idea can be modified by buying the homes a few years apart or buying lower priced homes and letting the children up-grade them later under their own steam. Instead of a ‘home for every child,’ it might become ‘half a home for every child.’

Call us old-fashioned, but strategies like this are often even more important for clients’ with daughters. It may be 80 years since the suffragettes but we still do not have equal incomes or workplace opportunities. Most women of retirement age have around 1/3 of the super balances of men the same age. And women live longer as well. Virginia Woolf wrote about the importance of a woman having money and a room of one’s own. Clients should consider buying their daughters a whole house.

Strategies for Adult Children with Above Average Wealth

Inter-generational financial planning is not just about helping low-income children. It can work the other way too. Often, the adult children are doing quite well and have retired parents who are asset rich and income poor, in their sixties and seventies and not working full time, if at all. Often, these self-funded retiree parents do not pay tax: their super is all tax-free.

Higher Wealth Children – Retired Mum and Dad as Investment Managers

Consider Mario as an example. Mario was born and raised in Strathfield in Sydney. He still lives there, and his parents live around the corner. They baby-sit the grand-kids every day, and they helped Mario get through university, set up his financial planning practice and buy his home. Mario’s family are close, in that Mediterranean way. They share everything. Sometimes this grates on Mario’s Anglo wife, Melinda, but mostly it is good.

Mario’s parents are worth about $4,000,000. They have their home, their super and a couple of local investment properties. Life is good. Except they are bored: they previously enjoyed active working lives and the Strathfield Bowls Club just doesn’t do it for them. Too many old people complaining about their ne’er-do-well children, they say.

Mario sold part of his financial planning practice to a partner for $500,000 in early 2015. The $500,000 was tax free under the CGT small business exemptions. He now wants to invest $500,000, but does not have the time to do this. His days are still spent at his practice and when he gets home he wants to be a good dad to his young family. Mario Junior is showing potential as a Socceroo.

So Mario forms a new investment trust with his mum and dad as directors and primary beneficiaries. Mario puts in $500,000 capital. The trust borrows another $1,000,000 at 5% interest and invests $1,500,000 in blue chip Australian shares. Mario’s parents administer the trust, along with their other investments. The Mario Investment Trust expects to earn 9.5% per annum based on the last two decades (taking the ASX Long Term Investment Report of July 2015 as its guide), which means it is anticipated to earn $142,500 (including unrealised capital gains), less $50,000 of interest. The net income (excluding unrealised capital gains) will be about $50,000. This will be distributed to Mario’s parents as a reward for their time and skill in managing the investments.

This means the capital is effectively invested tax free, with excess franking credits refunded.

This is a powerful planning strategy: it allows Mario’s $500,000 to be invested virtually tax free, which compares extremely well with alternative strategies including super. Remember: a tax dollar saved is an extra dollar invested, with an exponential compounding effect over time.

As always, please feel free to send through your thoughts and comments about the strategies above – or any other strategies that you think are worth considering when it comes to IFP.

The Dover Group